Consider the following information for Magical Interactions, Inc.
Based on the assumptions above, which of the following statements is TRUE?
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A. B. C. D.D
The expected inflation rate is a component of ke (through the nominal risk free rate). ke is one component of the P/E ratio and can be represented by the following: nominal risk free rate + stock risk premium, where nominal risk free rate = [(1 + real risk free rate) * (1 + expected inflation rate)] "" 1.
The other statements are false. To determine the stock over/under valuation, we need to calculate both the P/E ratio and the EPS.
The P/E ratio = Dividend Payout Ratio / (ke"" g),
EPS = [(Per share Sales Estimate) * (EBITDA%) "" D (per share) "" I (per share)] * (1 - t)
= [($150 * 0.18) - $15 - $10] * (1 "" 0.35) = $1.30
Value of stock = EPS * P/E = 7.14 * $1.30 =$9.30
Since the market value of the stock is greater than the estimated value, the stock is overvalued.
An increase in earnings retention will likely decrease the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay dividends (absent tax concerns).
Investors will likely value the company lower if it retains a higher percentage of earnings.
If management increases EBITDA by 1.0%,the stock will be undervalued.
EPS = [($150 * 0.19) - $15 - $10] * (1 "" 0.35) = $2.28
Value of stock = EPS * P/E = 7.14 * $2.28 = approximately$16.30, which is greater than the market value.
Note: the EBITDA % that equates to the market price is approximately 18.5%, or a 0.5% increase. Small changes in EBITDA% have a large impact on the EPS and thus on the estimated stock value.